Peter is grappling with a dilemma that is both logistically and emotionally challenging. The business consultant is about to inherit around £250,000 and the sum will substantially ease his looming retirement: at 63 he describes himself as “transitioning out of work”.
Peter, not his real name, is receiving the life-changing sum after both his parents died last year. He is still dealing with the pain of his father’s passing — the more recent bereavement of the two. But at the same time he faces choices about how best to put the money to work in his pension, when to make charitable donations and how he should invest the remainder.
A mixture of high house prices, parental thrift and the prosperity of the postwar baby boom generation means thousands of people in the UK face such decisions every year. Speaking to FT Money, windfall recipients describe grappling with how much to add to their pension pots, how quickly to pay off their mortgages, and how best to ensure a secure financial future for their children, grandchildren or other people they want to help.
Heirs and financial planners also describe how calculations are shaped by considerations such as the length of time they expect to continue working, whether they have a mortgage and whether they want to pass on money quickly to children.
Family money or risk capital?
Peter, whose solicitors are currently applying for probate — the formal declaration of validity — on his father’s will, says his main concern is to optimise his use of the money. Like many other inheritors, he says his parents never expressed a preference for how he should use the money.
“I’m just trying to work out what to do when this comes,” he says of the money.
Yet David Hearne, a chartered financial planner for FPP, a consultancy based in Berkshire, says many heirs have conflicted feelings about inheriting — and that their feelings can be critical to how they manage the money.
Some inheritors regard receipt of a windfall as an opportunity to take new risks, Hearne says.
Elaine, 59, adopted such an attitude following her mother’s death 18 months ago. Elaine — like all the heirs mentioned she asked to be referred to by an assumed name — describes the £300,000 inheritance as a “facilitator”. Her mother would want her to have the wider opportunities that the windfall affords, says Elaine, who works in professional services, says.
“This money at least gives me the opportunity to think what can I do sooner rather than later, whether that’s reducing the number of hours I might work or have more retirement,” she says.
However, other recipients handle inherited wealth more cautiously than money they have earned, according to Hearne. Among them is Frida, 70, who considers the several hundred thousand pounds she inherited four years ago is only conditionally hers.
“My parents always regarded it as family money,” she says. “If we needed it, we could use it even before their deaths. But if we didn’t need it, it was to go on to the next generation.”
Hearne says part of his work is helping people to understand that the money they have inherited genuinely belongs to them.
“Very often people will keep it in a separate account because it’s part of the inheritance,” Hearne says. “For us, it’s about understanding if that’s just an emotional barrier they should get through or it’s a very strong emotional thing.”
For those most determined to regard the inheritance as separate, his firm will sometimes segregate the money, Hearne adds. Heirs will sometimes decline to make any financial decisions until that has happened, he adds.
Peter, who buried his father around three months ago, says the money “feels quite empty in a way”. “It would have had more meaning if it was winning the premium bonds.”
But his lack of strong feelings about the money has left him without firm ideas over how to deploy it.
“There’s no great need. There’s not a project. There’s not a great difficulty to be resolved,” Peter says.
Pension boost
He has nevertheless started to think about how his windfall might boost his pensions — currently a mix of the state pension, a defined benefit fund from a past employer and a defined contribution element from his current role, where he is self-employed.
Extra contributions — up to an annual limit of £60,000 or the saver’s annual earnings, whichever is lower — come out of the saver’s pre-tax income. Any pension fund passed on at death falls outside the total assessed for inheritance tax.
Joanna Little, chief executive of Emery Little, a Hertfordshire-based financial planner, advocates strongly for anyone receiving a windfall to make such contributions if they are working and have spare money.
“It’s a very tax-efficient way of investing, especially if you’re planning for retirement and you’re likely to be paying a lower rate of tax when you retire than today,” she says.
For most workplace pensions that allow direct contributions from salaries, extra payments are also exempt from national insurance premiums, Little points out.
The only constraint on making the maximum possible pension contribution each year, she says, is that investors should leave themselves a financial reserve for contingencies.
“Do you have a cash buffer so that you’re really comfortable, so that if the boiler breaks you’ve got accessible cash you can get to with no penalty that you could use?” she says people should ask themselves. “Making sure you’ve put that aside, think about pensions.”
For Elaine, meanwhile, the priority is to pay off the mortgages on the investment properties she owns. She uses the rental income to make the mortgage payments but says paying down the mortgage will protect her in the event of a problem with a difficult tenant.
“You put money in order for you to have not too many rushed decisions, such as selling something or going bust because you haven’t got the money to cover it if somebody won’t get out of the property,” she says.
Hearne warns against assuming that paying down a mortgage is always prudent. For many clients, he says, the interest earned from an investment in an individual savings account (Isa) will be greater than the saving the same money would generate if deployed to pay down a mortgage. Extra pensions payments can be particularly attractive, according to Hearne.
“More and more people are continuing their mortgages into retirement because they’ve done cash flow modelling . . . which says the best thing . . . is not to clear my mortgage — it’s to put it into my pension,” Hearne says.
Yet, as with other issues around inheritances, questions about mortgages for many people come down to emotion. Little says that for many people the relief of being mortgage free trumps strict financial logic.
“In all my work with clients, I’ve yet to meet somebody who regretted paying down their mortgage,” she says. “You finally own your own home. You suddenly have more disposable income to do something else with. It’s something to reduce the worry. That’s hard to quantify in assessment terms.”
The strictly practical case for paying down a mortgage has also improved in recent years, Little points out. Interest rate rises have driven up either the rates that borrowers are currently paying for mortgages or the rates those on fixed-rate deals will have to pay when those deals end.
Elaine says she wants peace of mind. “I think my overarching goal is the security of knowing that at least I haven’t got that bit of a question mark hanging over my head — where is the interest rate going?” she says.
Spend or save?
Peter has no outstanding mortgage and expects that, because his earnings are declining, he will be able to put only a total £110,000 extra into his pension.
The sum reflects the contributions he expects to make based on his earnings before retirement and the use of a “track back” provision in the tax rules. This allows savers under some circumstances to use any unused allowance in the three previous tax years to make retrospective extra contributions for those years.
On top of that, Peter plans to use up his allowance for Isas. But contributions to those are limited to £20,000 a year. That leaves much of his expected windfall undeployed.
Hearne says that, as well as investing, he often encourages people in such a situation to spend on things they would enjoy.
“If people have seen their parents working to save and maybe going without, they don’t feel able to use their money on kitchens or cars because that feels wasteful,” Hearne says. “A lot of my work is encouraging people to spend money on their own lives because it’s not extravagant because they’ve done the planning for the future.”
Little says she similarly tries to give clients licence to cater to their own needs, rather than focusing on passing money on.
Because her mother died quickly and unexpectedly, Elaine recognises the value of spending. She has no children to whom to leave her windfall.
“I’ve realised how swiftly life can disappear,” she says. “You could have been scrimping and saving and find you leave it to potentially the tax man. There should be a balance.”
Peter, however, says he has relatively simple tastes. While he enjoys foreign travel, he and his partner typically take holidays by swapping their home in the UK with the properties of people abroad.
“I wouldn’t be doing a lot of spending,” he says.
Investment choices
He is worried instead about taking the right amount of risk with any new investments, inside or outside an Isa. Little advocates that investors should keep the money they need for the next two to three years in a non-volatile form such as a bank savings account. But resources for the longer term should be in faster-growing but riskier equities, she says.
“If you have everything in cash, that’s not going to give you a great chance of maintaining the purchasing power of your money over the 30 years in retirement,” Little says.
Hearne says his firm assesses customers’ “risk capacity” — their tolerance for fluctuations in value. That is a useful addition, he says, to advisers’ standard test of “risk appetite”. Those tests, Hearne says, use questionnaires about attitudes to risk that only partly reflect the role of risk in meeting clients’ needs.
“When we talk about risk, really it’s the risk of volatility,” Hearne says. “It’s not really the risk of losing the money. It’s the risk that the money will go up and down. If you don’t need that money for 20 years, you have the capacity to take the risk in a way that someone who needs the money in two years doesn’t.”
Some people planning for retirement should be taking on extra risk, Hearne adds. Lengthening life expectancies mean a 50-year-old could easily need his or her investments to last another 40 years.
“If someone is planning out at the age of 50 potentially 40 more years of their life, most of which will be not working, there’s often a requirement for risk if that money is going to retain its purchasing power,” Hearne says. “The recent high inflation is a reminder of how inflation can destroy purchasing power.”
Peter recognises that a financial planner might suggest he should take more risks — his father lived into his 90s and Peter says he looks after his health.
“I should plan for a long life,” he says.
He hopes eventually to pass on a substantial amount to both his children and grandchild, he adds. He will also give money in his will to conservation charities that he supports.
But he hopes as a result of his windfall to witness the effects of some donations for himself.
“Some of it will go to charities in my will,” Peter says. “I think it’s very likely I’ll want to give some charity money out before then and see what happens with it.”
The plan chimes with much of the advice from both Little and Hearne about how people inheriting money should think about their situation. Hearne says people often ask him how they should invest their money — but there are deeper issues.
“The bigger question is, ‘What do you want to do within your life?’” Hearne says. “Money is a tool, ultimately, because it allows someone to unlock their life.”
Tax on death is not inevitable
One worry for many people inheriting from their parents is how to ensure the money incurs as little tax as possible when they pass it on to their own children. It is a largely misplaced concern, according to Joanna Little, chief executive of financial planners Emery Little.
Inheritance tax, which applies only to estates of more than £325,000, does not apply to assets passed to a surviving spouse or civil partner at death. The upper limit rises to £500,000 if the deceased passes on their home to their children. On top of that, when someone has died after his or her spouse or civil partner, the heirs can use any unused inheritance tax allowance from the first death on top of the allowance for the second.
“The majority of people in the UK won’t have to worry about inheritance tax,” Little says.
Anyone worried about inheritance tax can nevertheless reduce the liability by signing a deed of variation of the parent’s will and pass all or some of the money immediately to someone else. A deed has to be issued within two years of the death.
However, David Hearne, a chartered financial planner for Berkshire-based FPP, warns that heirs should think carefully before taking such steps.
“For a lot of people, unless they’ve done their own financial planning, they can’t make the decisions about whether they need the money for their own lives or can afford to engage it for the benefit of future generations,” Hearne says.
Little shares Hearne’s caution, saying inheritance tax planning is the “cherry on the financial planning cake” and should not be the “most important thing”.
“The most important thing is making sure you’re OK in your own lifetime,” she says.
She acknowledges that some financial planners offer clients vehicles such as trusts intended to help them to minimise their inheritance tax liabilities.
But she advocates two more straightforward steps.
“The best ways of reducing inheritance tax are spending . . . and gifting during your lifetime,” Little says.
